Accounting principles 10e by kieso chapter 18

18-13 SO 5 Identify and compute ratios used in analyzing a items of financial statement data.. 18-14 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability,

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18-1

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CHAPTER 18

Financial Statement Analysis

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18-3

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SO 1 Discuss the need for comparative analysis.

SO 2 Identify the tools of financial statement analysis.

Basics of Financial Statement Analysis

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18-5 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis

technique for evaluating a series of financial statement data

over a period of time

has taken place

statement, and statement of retained earnings

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Changes suggest that the company expanded its asset base during 2009

and financed this

expansion primarily

by retaining income

rather than assuming additional long-term debt.

Illustration 18-5

Horizontal analysis of balance sheets

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Overall, gross profit and net income were

up substantially

Gross profit increased 17.1%, and net income, 26.5%

Quality’s profit trend appears favorable.

Horizontal analysis of Income statements

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In the horizontal analysis of the balance sheet the ending retained earnings increased 38.6% As indicated earlier, the company retained a significant portion of net income to

finance additional plant facilities.

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18-9 SO 4 Describe and apply vertical analysis.

technique that expresses each financial statement item as

a percent of a base amount

 On an income statement, we might say that selling

expenses are 16% of net sales

 Vertical analysis is commonly applied to the balance

sheet and the income statement

Vertical Analysis

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These results reinforce the earlier observations that

Quality is choosing to finance its growth through retention

of earnings rather than through

issuing additional debt.

Vertical analysis of balance sheets

SO 4 Describe and apply vertical analysis.

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Quality appears

to be a profitable enterprise that is becoming even more successful.

Vertical analysis of Income statements

SO 4 Describe and apply vertical analysis.

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18-13 SO 5 Identify and compute ratios used in analyzing a

items of financial statement data

Measures

short-term ability of the

company to pay its

maturing obligations and to

meet unexpected

needs for cash.

Financial Ratio Classifications

Measures the income or operating success

of a company for a given period of

time.

Measures the ability of the company to survive over a long period of time.

Ratio Analysis

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firm’s liquidity, profitability, and solvency.

The discussion of ratios will include the

following types of comparisons

A single ratio by itself is not very meaningful

Ratio Analysis

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18-15

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SO 5 Identify and compute ratios used in analyzing a

Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash

 Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity

 Ratios include the current ratio, the acid-test ratio,

receivables turnover, and inventory turnover

Ratio Analysis

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Ratio of 2.96:1 means that for every dollar of current liabilities,

Quality has $2.96 of current assets.

1 Current Ratio

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Ratio Analysis

2 Acid-Test Ratio

Liquidity Ratios

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18-20

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Measures the number of times, on average, the company collects

receivables during the period.

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A variant of the receivables turnover ratio is to convert it to

Receivables are collected on average every 36 days

$2,097,000 ($180,000 + $230,000) / 2

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Measures the number of times, on average, the inventory is sold

during the period.

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A variant of inventory turnover is the days in inventory

Inventory turnover ratios vary considerably among

industries

365 days / 2.3 times = every 159 days

$1,281,000 ($500,000 + $620,000) / 2

= 2.3 times

Inventory Turnover

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Profitability Ratios

Measure the income or operating success of a company for a given period of time

 Income, or the lack of it, affects the company’s ability to

obtain debt and equity financing, liquidity position, and the ability to grow.

 Ratios include the profit margin, asset turnover, return

on assets, return on common stockholders’ equity,

earnings per share, price-earnings, and payout ratio.

Ratio Analysis

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Ratio Analysis

7 Return on Asset

An overall measure of profitability.

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Ratio Analysis

8 Return on Common Stockholders’ Equity

Shows how many dollars of net income the company earned for

each dollar invested by the owners.

SO 5

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Ratio Analysis

9 Earnings Per Share (EPS)

A measure of the net income earned on each share of common

stock.

SO 5

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Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time

 Debt to Total Assets and

 Times Interest Earned

are two ratios that provide information about debt-paying ability.

Ratio Analysis

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Ratio Analysis

12 Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

SO 5

Solvency Ratios

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Ratio Analysis

13 Times Interest Earned

Provides an indication of the company’s ability to meet interest

payments as they come due.

SO 5

Solvency Ratios

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Summary of Ratios

SO 5

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18-38 SO 6 Understand the concept of earning power,

and how irregular items are presented.

obtained in the future

statement Two types are:

1 Discontinued operations

2 Extraordinary items

“Irregular” items are reported net of income taxes.

Earning Power and Irregular Items

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(a) Disposal of a significant component of a business.

(b) Report the income (loss) from discontinued operations

in two parts:

1 income (loss) from operations (net of tax) and

2 gain (loss) on disposal (net of tax)

SO 6 Understand the concept of earning power,

Discontinued Operations

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Illustration: During 2012 BD Inc has income before income

taxes of $79,000,000 During 2012, BD discontinued and sold its unprofitable chemical division The loss in 2012 from chemical

operations (net of $135,000 taxes) was $315,000 The loss on

disposal of the chemical division (net of $81,000 taxes) was

$189,000 Assuming a 30% tax rate on income

SO 6

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Other revenue (expense):

Interest revenue 17,000 Interest expense (21,000) Total other (4,000) Income before taxes 79,000 Income tax expense 24,000

Income from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315 Loss on disposal, net of tax 189 Total loss on discontinued operations 504

Net income $ 54,496

Income Statement (in thousands) Sales $ 285,000 Cost of goods sold 149,000

Discontinued

Operations are reported

after “Income from

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Nonrecurring material items that differ significantly from a

company’s typical business activities

 Must be both of an

► Unusual Nature and

► Occur Infrequently

 Must consider the environment in which it operates

 Amounts reported “net of tax.”

Extraordinary Items

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Are these considered Extraordinary Items?

(a) A large portion of a tobacco manufacturer’s crops

are destroyed by a hail storm Severe damage from hail storms in the locality where the

manufacturer grows tobacco is rare

(b) A citrus grower's Florida crop is damaged by

frost

(c) Loss from sale of temporary investments

(d) Loss attributable to a labor strike

YES

NO NO

NO

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(d) Loss from flood damage (The nearby Black River

floods every 2 to 3 years.)

(e) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company

Earthquakes are rare in this geographical location

(f) Write-down of obsolete inventory

(g) Expropriation of a factory by a foreign

government

NO

YES

NO

Are these considered Extraordinary Items?

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Illustration: In 2012 a foreign government expropriated property held as an investment by DB Inc If the loss is $770,000 before applicable income taxes of $231,000, the income statement will report a deduction of $539,000

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Other revenue (expense):

Interest revenue 17,000 Interest expense (21,000) Total other (4,000) Income before taxes 79,000 Income tax expense 24,000

Extraordinary loss, net of tax 539

Net income $ 54,461

Extraordinary Items are

reported after “Income

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Interest expense (21,000) Total other (4,000) Income before taxes 79,000 Income tax expense 24,000

Discontinued operations:

Loss from operations, net of tax 315 Loss on disposal, net of tax 189 Total loss on discontinued operations 504

Income before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income $ 53,957

Reporting when both

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18-48

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 Occurs when the principle used in the current year is

different from the one used in the preceding year

 Accounting rules permit a change if justified

 Changes are reported retroactively

 Example would include a change in inventory costing

method such as FIFO to average cost

Change in Accounting Principle

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Total operating expense 53,000

Income from operations 83,000

Other revenue:

Interest revenue 17,000

Total other 17,000

Income before taxes 100,000

Income tax expense 24,000

Unrealized gains and losses on available-for- sale securities.

Plus other items

+

Reported in Stockholders’

Equity

Comprehensive Income

All changes in stockholders’ equity except those resulting from investments by

stockholders and distributions

to stockholders.

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Why are gains and losses on available-for-sale securities

excluded from net income?

Because disclosing them separately

1) reduces the volatility of net income due to fluctuations in

fair value, 2) yet informs the financial statement user of the gain or loss

that would be incurred if the securities were sold at fair value

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Companies have incentives to manage income to meet or

beat Wall Street expectations, so that

 the market price of stock increases and

 the value of stock options increase

A company that has a high quality of earnings provides full

and transparent information that will not confuse or mislead

users of the financial statements

SO 7 Understand the concept of quality of earnings.

Quality of Earnings

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 Variations among companies in the application of GAAP

may hamper comparability and reduce quality of earnings

 Pro forma income usually excludes items that the

company thinks are unusual or nonrecurring

 Some companies have abused the flexibility that pro

forma numbers allow

Pro Forma Income

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Some managers have felt pressure to continually increase

earnings and have manipulated the earnings numbers to meet

these expectations

Abuses include:

 Improper recognition of revenue (channel stuffing)

 Improper capitalization of operating expenses

(WorldCom)

 Failure to report all liabilities (Enron)

Improper Recognition

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 The tools of financial statement analysis covered in this chapter

are universal and therefore no significant differences exist in the analysis methods used

 The basic objectives of the income statement are the same

under both GAAP and IFRS Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from irregular items in order to better predict a company’s future profitability

 The basic accounting for discontinued operations is the same

under IFRS and GAAP.

Key Points

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 Under IFRS, there is no classification for extraordinary items In

other words, extraordinary item treatment is prohibited under IFRS All revenue and expense items are considered ordinary in nature

 The accounting for changes in accounting principles and

changes in accounting estimates are the same for both GAAP and IFRS.

 The income statement under IFRS is referred to as a statement

of comprehensive income The statement of comprehensive income can be prepared under the one-statement approach or the two-statement approach.

Key Points

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 The issues related to quality of earnings are the same under

both GAAP and IFRS It is hoped that by adopting a more principles-based approach, as found in IFRS, many of the earnings’ quality issues will disappear.

Key Points

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The FASB and the IASB are working on a project that would rework the structure of financial statements Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP In addition, another part of this project

addresses the issue of how to classify various items in the income statement A main goal of this new approach is to provide

information that better represents how businesses are run In

addition, the approach draws attention away from one number— net income.

Looking to the Future

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